The spectre of a crippling bout of deflation is hanging over the global economy.
Fuelled by continuing overcapacity, shrinking credit, reduced corporate spending and falling consumer demand, deflation is on the rise in its old stomping ground of Japan and taking root in the battered U.S. and European economies.
Consumer prices fell at their fastest clip ever last month in Japan, which has been fighting a losing war against deflation for much of the past two decades. Germany, Europe's biggest economy, has now suffered through four consecutive months of sliding prices, and the rest of the region that uses the euro is not faring much better.
That deflation should be such a threat may run counter to market fears that inflation will quickly follow the massive, and costly, global effort to fight the financial crisis. But many observers see deflation as the greater threat.
That's because it's harder to stamp out once it becomes embedded in an economy, as happened during the Great Depression.
The result would inevitably be years of dismal economic performance, staggering unemployment, and deeply pessimistic consumers and businesses that cease spending and focus on surviving, economy watchers warn.
Famed bond investor Bill Gross is loading up on longer-term government bonds to capitalize on his view that the U.S. is facing just such a grim development.
"We are certainly in a deflationary state," said David Rosenberg, chief economist and strategist with Gluskin Sheff and Associates in Toronto. "Of that, there's no doubt," Mr. Rosenberg said.
Inflationistas fear that massive government injections of cheap money into the economy are about to send asset values and prices skyrocketing.
On Tuesday, Richard Fisher, president of the Federal Reserve Bank of Dallas and a prominent inflation hawk, said the U.S. central bank could raise interest rates quickly if the economy stabilizes. But he pointedly added that there may be deflationary risks in the near term and rising unemployment.
"While the commentariat is focused on inflation, the real issue for now is deflation, driven by virtually 10-per-cent unemployment in the U.S., Germany, France, Italy, China, India et al," said Ken Courtis, an investment banker based in Hong Kong and an expert on Japan and other Asian economies.
In Japan, a succession of governments have tried every trick in the playbook to inflate the economy. Nothing seems to have had a lasting effect.
"While Japan counts unemployment somewhat differently, it is running at close to 6 per cent, and if you consider that the labour market is contracting at about 1.1 per cent [annually] you can get a sense of the intensity of the downdraft," Mr. Courtis said.
Japan is exporting far fewer of the products that once made its economy so successful. For example, auto exports are about half the level of the previous five years, sidelining plants, workers, and parts and materials suppliers.
Americans and others could face a similar fate as the "Japanese disease" spreads, although the Federal Reserve and other central banks have moved faster and much more aggressively than the Japanese in efforts to counter deflationary dangers.
"I think people still have no clue as to just how weak the economy is," Mr. Rosenberg said.
Remove the "impressive medication" administered by governments, and most economies are at a virtual standstill.
The U.S. economy faces a decade of stagnation, he said. "That's a perfectly plausible scenario."
Not every economy watcher buys the deflation scenario, however.
"It may be a boring story, but neither deflation nor inflation is a particular risk," said Avery Shenfeld, chief economist at CIBC World Markets.
Indeed, during this recession Canada has so far been spared some of the conditions that pave the way for deflation, such as falling wages. But if the virus hits in the United States, it could easily spread north. And the fragile U.S. economy is extremely vulnerable just now. U.S. lending has been contracting at record levels, excess manufacturing capacity is widespread, consumers have curtailed spending, real wages are falling and unemployment is still rising.
Including the underemployed, the U.S. jobless rate is actually 17 per cent, nearly double the official rate of 9.5 per cent, Mr. Rosenberg said.
To prevent a deflationary outcome, policy makers have to stop worrying about how they'll rein in future deficits and start persuading the public that they'll do whatever it takes to keep the pumps primed and cash savings nearly worthless, said Arthur Heinmaa, managing partner with Toron Capital Markets in Toronto.
The lessons from Japan show that officials have to be "credibly reckless," Mr. Heinmaa said, paraphrasing one of Federal Reserve Board chairman Ben Bernanke's lines.
If and when it does hit, "deflation will last until we see the next secular trend of expanding household balance sheets, and that is some time away," Mr. Rosenberg said.Report Typo/Error